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Friday, September 27, 2013

While I was away from blogging, two places that kept the Market Monetarism torch burning were the National Review and the American Enterprise Institute. Not everyone at these institutions are fans of Market Monetarism, but National Review Senior Editor Ramesh Ponnuru and AEI columnist Jim Pethokoukis are and produced some great articles. These two individuals happen to be highly influential conservative thought leaders. Thanks to them we are making some inroads on the right. Below are some of the pieces they wrote.

Five years into the crisis and the Fed still has not adopted a nominal GDP level target. At least we can take solace in the fact that the Fed now has an explicit inflation target, right? After all, the Fed stated it was serious about its new 2% inflation target when announced in January, 2012:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

Now an inflation target can be problematic if there are large and frequent supply shocks, but if we are in a slump that is largely the result of demand shocks this target should be good news. It should hold the Fed's feet to the fire--more so than when it was implicitly targeting inflation--and force it to do all the wonderful things promised in the paragraph above.

So let's see how the Fed has done by its own standard of targeting 2% PCE core inflation:

This is not what the Fed promised with its new inflation target. Instead of gravitating around an average 2% inflation target, the Fed seems to have made 2% an upper bound. And the lower bound appears to be around 1%. This band seems to have been operational since the crisis began. It also appears that the Fed's purchases of treasury securities are closely tied to subsequent changes in the inflation rate as seen below. Maybe the apparent make-it-up-as-we-go-along nature of the QE programs was not so ad-hoc after all. Maybe they always have been tied to keeping PCE core inflation in this band.

Just this week Justin Wolfers noted that the PCE deflator declined this past quarter. He wondered how the Fed could allow this to happen if it had a 2% inflation target. The answer, it seems, is the Fed is targeting an inflation band with 2% as the upper bound.

This is a point Ryan Avent has been making for some time. Here he is back in April, 2012:

The Fed's second failure is to treat the 2% figure as a ceiling
rather than a target...The Fed's preferred inflation measure—core PCE
inflation—remains below 2%; core PCE was 1.9% year-on-year in February,
in which month it increased at a 1.6% annual rate. Inflation
expectations have been stable to falling since then.

Perhaps more telling, the Fed gives a range for projected inflation
over the next three years with 2% as the upper extent. If the Fed does
indeed have a symmetric approach to the target, as Mr Bernanke asserted
yesterday, one would expect 2% to be at the middle of the
range, not the top. This is particularly damning as the Fed's estimate
of the natural rate of unemployment doesn't appear at all in
the projected unemployment-rate range over the next three years; the
closest the Fed comes to meeting that side of the mandate is in 2014,
when the bottom end of the projected unemployment-rate range gets within
0.7 percentage points of the top end of the natural-rate range.

The
Fed isn't just failing on the guideposts set by economists like Paul
Krugman, Kenneth Rogoff, Greg Mankiw and, yes, Ben Bernanke. It's
failing on the terms it sets for itself. Consistently.

So exactly what has changed with the Fed's new inflation target? Other than creating more confusion, nothing. And the Fed seems to be getting really good at creating confusion as evidenced by the no taper fiasco. This has to stop. We need monetary policy that will respond in a predictable, systematic way conditional on the state of the economy. Right now the Fed is not doing that.

Wednesday, September 25, 2013

Can monetary policy still pack a
punch at the zero lower bound (ZLB)? For Market Monetarists, the answer
is an unequivocal yes. For others, the answer is less clear. Paul
Krugman, for example, made the following comment recently on the efficacy of monetary policy during liquidity traps:

[T]he liquidity trap is real; conventional monetary policy, it turns out,
can’t deal with really large negative shocks to demand. We can argue
endlessly about whether unconventional monetary policy could do the
trick, if only the Fed did it on a truly huge scale..

Krugman
is right, this issue is contentious. It has been argued almost
endlessly over the past five years. I submit, however, that over this
time we have had several quasi-natural experiments on the effectiveness
of monetary policy at the ZLB. These "experiments" along with an earlier
one have shed some light on this issue.

The
first quasi-natural experiment has been happening over the course of
this year. It is based on the observation that monetary policy is being
tried to varying degrees among the three largest economies in the
world. Specifically, monetary policy in Japan has been more aggressive
than in the United States which, in turn, has had more aggressive
monetary policy than the Eurozone.1 These economies also haveshort-term interest rates near zero percent. This makes for a great experiment on the efficacy of monetary policy at the ZLB.

So
what have these monetary policy differences yielded? The chart below
answers the question in terms of real GDP growth through the first half
of 2013:

The
outcome seems very clear: when really tried, monetary policy can be
very effective at the ZLB. Now fiscal policy is at work too, but for
this period the main policy change
in Japan has been monetary policy. And according to the IMF Fiscal
Monitor, the tightening of fiscal policy over 2013 has been sharper in
the United States than in the Eurozone. Yichang Wang illustrates this
latter point nicely in this figure.
So that leaves the variation in real GDP growth being closely tied to
the variation in monetary policy. Chalk one up for the efficacy of
monetary policy at the ZLB.

The
second quasi-natural experiment has been running since 2010 in the
United States. Over this period the cyclically-adjusted or structural
budget balance as a percent of potential GDP has been shrinking. This is
the best measure of the stance of fiscal policy, as noted by Paul Krugman:

[M]easuring
austerity is tricky. You can’t just use budget surpluses or deficits,
because these are affected by the state of the economy. You can — and I
often have — use “cyclically adjusted” budget balances, which are
supposed to take account of this effect. This is better; however, these
numbers depend on estimates of potential output, which themselves seem
to be affected by business cycle developments. So the best measure,
arguably, would look directly at policy changes. And it turns out that
the IMF Fiscal Monitor provides us with those estimates, as a share of
potential GDP...

Below is the IMF's measure of both the overall and primary structural budget balance for all levels of government:

So
what is the implication of this figure? First, it shows that
independent of business cycle influences fiscal policy has been
tightening since 2010. It has gone from an overall deficit of 8.5% in
2010 to an expected one of
about 4.6% in 2013. Stated differently, the above reduction in the
general budget
deficit is not the government endogenously
adjusting its balance sheet in response to improvements in the private
sector's balance sheet. Rather, it is the consequence of explicit policy
choices
to sharply tighten fiscal policy.

So
what have these three years of fiscal policy tightening done to
aggregate demand over this time? Apparently nothing as seen in the
figure below:

So
what explains this development? How is it that fiscal policy tightening
in conjunction with the Eurozone shocks, the China slowdown
shocks, and other negative shocks has not slowed down aggregate demand
growth? The answer is that Fed policy has effectively offset the effect
of the fiscal austerity and the other shocks. This is another great
quasi-natural experiment that demonstrates the effectiveness of monetary
policy even with interest rates close to zero percent. Chalk another
one up for the efficacy of monetary policy at the ZLB.

Of
course, this remarkable stabilization of U.S. aggregate demand growth
by the Fed has been far from adequate in terms of restoring full
employment. It is, therefore, ultimately frustrating to watch. For it
speaks to both the power and shortcomings of current Fed policy.

While
these recent quasi-natural experiments on the efficacy of monetary
policy at the ZLB are informative, an even more telling one can be found
in the 1930s. This is the quasi-natural experiment of advanced
economies going off the gold standard. As is well known, the interwar
gold standard was flawed and played a key role
in causing the Great Depression in the early 1930s. The countries
involved were in a slump and their interest rates were near zero
percent. Yet, as Eichengreen (1992) notes, the quicker a country abandoned the gold standard the quicker it experienced a robust recovery.

This
cross-country, quasi-natural experiment of the efficacy of monetary
policy at the ZLB should give any monetary skeptic pause. Christina
Romer notes
that in the case of the U.S. economy this recovery was almost entirely
the consequence of easing monetary conditions. Fiscal policy played little role.

These
three quasi-natural experiments indicate that there is much monetary
policy can do at the ZLB. If so, the key issue is why central banks did
not do more over the past three years to shore up the recovery.

1In more precise terms, the Bank of Japan has signaled more definitely than the Federal Reserve a permanently higher future monetary base level relative to the expected real demand for it. The Fed, in turn, has signaled the same relative to the ECB.

This is an email exchange I had with Miles Kimball on the Fed's new fixed rate, full allotment, reverse repo. We thought it was worth sharing with our readers. As noted in the email, I plan to do a follow up blog post that further examines the macroeconomic implications of this this new Fed tool. My discussion with Miles, though, gets to core of my concerns about the Fed's reverse repo. Thanks to Cardiff Garcia and Izabella Kaminski at FT Alphaville for helpingclarifythis issue. This is cross listed over at Mile's blog, Confessions of a Supply-Side Liberal.

David: I have been meaning to contact you. I am about to start blogging again and one of the issues I want to raise is the implication of the Fed introducing its fixed rate, full allotment, reverse repo. I understand the point that it will help with the collateral shortage problem in repo markets—though I think this point ignores the counterfactual of what would happened to repo markets had their been no QE—but I also see it as further cementing the ZLB. It, along with the IOR, will effectively create a floor on short-term interest rates given the Fed’s preferences to shore up money markets. While this may be a nice short-term palliative, I see it as creating problems in future recessions if Fed preferences for money markets do not change. This particularly seems problematic in light of what you have written about creating negative interest rates with e-money. Here is a twitter exchange with the folks at FTAlphaville on this issue.

Does this critique make sense? If I am missing something here please let me know.

Miles: Thanks for your kind tweet today!

I confess I don’t see the issue. If the Fed has a reverse repo rate, the Fed can lower that too, when needed. The key is that when the repo rate is introduced, it should be made clear that it might potentially go negative, and have the machinery for that in place.

In seminars on electronic money, I say that the Fed should move 4 interest rates in tandem:

1. fed funds rate

2. discount rate

3. interest rate on reserves (no longer on just excess reserves when it is negative)

4. paper currency interest rate

This would add a 5th:

5. reverse repo rate

I also emphasize in seminars that lowering 1—3 while keeping 4 the same leads to unnatural spreads, and these unnatural spreads could, in fact, be worrisome for financial markets. On the other hand, I wouldn’t want to discourage lowering 1—3, since I think it is a big step towards lowering 1—4. (Politically, the negative rates are the biggest deal, and the technical stuff to let the paper currency interest rate decline is more manageable politically once one has already taken the political hit from 1—3 going negative.) If all four interest rates—or now all five—are lowered in tandem, spreads are normal, and only nominal illusion and troubles lowering nominal wages are of concern.

In sum, if a reverse repo rate is introduced AND it is explicitly said at the time that it could go negative, that seems to me a good thing rather than a bad thing. But even if it is not explicitly said that it could go negative, I don’t see why that would be hard in the context of making 1—3 go negative, say. It is not like Japanese postal saving giving zero interest rates, where another institution is involved; all the rates are set by the Fed and it would only seem natural to lower the reverse repo rate if the others are lowered.

Am I missing something?

One side note: I confess that in a blog post about this, I would value highly a very detailed explanation of how the repo markets work, and what was going on with the negative interest rates in the repo market that you talked about here. What would be ideal would be an explanation understandable by a bright undergraduate with no experience in financial markets. Then maybe I can understand it, too!

In that context, the main thing to say is that the Fed should not be using the reverse repo rate to raise interest rates, when it is trying to keep other interest rates as low as possible. If the current repo rate is negative, the Fed should not raise that rate to zero. If the strains caused by abnormal spreads tempt them to do so, that is actually an argument for lowering the paper currency interest rate instead. Note the very important point that a modest lowering of the paper currency interest rate operative for financial firms can be achieved by a modest time-varying paper currency deposit charge when banks want to deposit paper currency with the Fed, without any other institutional change. (Because of the substantial transactions costs involved in taking someone to court, legal tender issues shouldn’t arise until paper currencies are several hundred basis points below zero, and in any case are manageable. Adjustments in how vault cash applies to reserve requirements are easy to make, if needed.) It would be great if this could be done in a somewhat quiet, technical-seeming way at this point. With that in place, it would be clearer that the interest rate on reserves (IOR) could be lowered.

David: Thanks Miles. No, I agree that introducing the IOR and the reverse repo in principle does not prevent the Fed from making rates go negative. (It may even make it easier to push rates negative since it has now has greater influence over more markets.) My concern is that the reason—at least what I have seen—for doing IOR and now the reverse repo is to help the interbank and repo markets. And in practice that means keeping these rates in these markets positive. For example, the reverse repo seems geared toward helping the collateral-starved repo market by reselling to it the much desired treasuries. But this would keep the repo rate up, or least keep it from falling.

So it is not the technical capability of the IOR and reverse repo that concerns me, but how it is being used. If this pattern continues, it seems the Fed will be further cementing the ZLB.

Miles: I think this is the unnatural spreads problem. As long as the paper currency interest rate is kept at zero, I think there is a genuine tension between wanting to keep normal spreads and wanting to keep interest rates down. Of course, QE is making other spreads unnaturally small. So it is a matter of being concerned about certain spreads. My image is not of cementing the zero lower bound, but adding a cushion to the zero lower bound to keep spreads from getting too thin. To the extent it is felt that that cushion is necessary to keep certain spreads from getting too thin, it makes the zero lower bound tighter than it otherwise would be. But the tension is all coming from the fixed paper currency interest rate.

I feel there can be legitimate disagreements about how much to worry about making certain spreads that are critical for certain financial institutions extra-thin and wanting to keep interest rates low. But what there should be no legitimate disagreement about (but of course, in fact there is plenty of disagreement about) is about the virtues of lowering all interest rates in tandem, including the paper currency interest rate. My UK friends Tomas Hirst and Frances Coppola have not fully come around to my view that with normal spreads, financial institutions will be fine even with negative interest rates. (See the links on their names, and my many discussions with them chronicled on my electronic money sub-blog.) But I think that is basically right, at least given a little advance warning of negative rates in order to adjust the nominal illusion bits of their business models. The strains on financial institutions from lowering all interest rates but the paper currency interest rate should not be extrapolated to a situation where all interest rates are lowered, including the paper currency interest rate.

David: Great point. If all interest rates are lowered in tandem so that spreads are relatively stable, then negative interest rates should not be a problem for financial firms. Their net interest margins will be stable too and financial intermediation should continue. That is a neat way to frame this issue.